July 2018 Newsletter

What’s in Store for the Rocky Financial Markets in the Second Half of 2018?

We are now past the halfway point of 2018, and, as far as the financial markets go, the contrast between what we experienced last year and what’s happened so far this year could not be more extreme. What do the next six months hold in store? No one can say for sure, of course, but if you have money in the markets, it’s certainly important to consider the different possibilities.
A year ago, the stock market was ruled by hope, with Wall Street laser-focused on the economic promise of Donald Trump’s corporate tax cuts. In fact, the VIX Index, which measures market volatility, was historically low in 2017, never once spiking above its long-term average of 19.4.1. Since early February, the exact opposite has been true. By mid-April, the S&P 500 had already moved up or down at least 1 percent 28 times, compared to just eight such swings for all of last year. The Dow and Nasdaq have been equally volatile.2
What’s been driving all the uncertainty? Well, several things, but most recently and consistently, it has been the increasing threat (and actual impacts) of a trade war, as Donald Trump seeks to balance unfair tariff schedules with China, the European Union, and other countries. Those worries ramped up as June came to a close, with the Dow tumbling 328 points on June 25 after posting a 2 percent decline the week earlier. That was its biggest weekly decline since late March. The S&P 500 also fell 1.4%, while the Nasdaq dropped 2.1%.3
The pullback came after a relatively long stretch of gains, continuing the cycle of dramatic ups and downs that began in February. Back then, Wall Street’s main worries were the over-hyped prospects of inflation and rising interest rates. Starting in April, however, the bigger concern became Trump’s verbal sparring over tariffs with several world leaders.

Threats Becoming Realities
Even before any new tariffs were actually imposed, the markets dipped because—as I’ve often explained—the financial markets are forward-looking and driven largely by emotion, namely optimism and pessimism or greed and fear. Three months later, however, the impacts Wall Street most feared from Trump’s tough stance on trade are now showing signs of becoming realities. In the midst of the volatility in late June, for example, Harley-Davidson announced it would move production of its motorcycles shipped to the EU overseas based on the fact that new EU tariffs would cost the company $90 to $100 million a year.
Naturally, the announcement fueled worries that new tariffs could lead to similar moves by other U.S. companies. That could further undercut the prospect of all the economic growth that’s supposed to result from Trump’s tax cuts, which Wall Street was very optimistic about a year ago.
While it’s still possible that equitable trade agreements will be reached and help improve the U.S. economy in the long-run, that won’t matter if there is enough short-term pain to spook investors into a major sustained sell-off. And let’s not forget, there are many other deeply concerning details about this market and the current state of the economy that go well beyond the trade-war issue.
As you may know, the Federal Reserve approved its second short-term interest rate hike of the year in June, bringing the current Fed funds rate up to 2 percent. They did this despite the fact that inflation is still below their 2 percent target and long-term rates are still stuck below three percent. Increasingly, they are flattening the yield curve, which could potentially hinder one of the most vital components of a strong economy: lending and borrowing.

Resistance Level
I’ve explained before that I believe long-term rates are going to continue hitting a strong resistance level at just below or above three percent for a variety of reasons. At the same time, I also believe inflation is going to remain low and possibly even lead to deflation—largely because the people who make up the country’s largest consumer demographic, Baby Boomers, are beyond their spending years and are now focused on saving.
As for the economy, itself, in the first half of the year, certain indicators did continue to look decent. According to the Labor Department, the unemployment rate hit 3.9 percent in April, its lowest level since 2000. As for GDP growth, it came in at 2 percent for the first quarter and is expected to hit or top 3 percent for the second quarter.4 While that’s still a long way from the 4 percent Trump originally promised, keep in mind his tax cuts are only starting to have an effect. Once their full impact is felt, we could see growth increase further in the next six months.
But that’s only one possibility. Another possibility is that the impact of the tax cuts is greatly diminished by the effects of a trade war, or by a flattened yield curve, or by creeping deflation, or any of the other factors I’ve discussed. Oh, and let’s not forget our massive federal debt, which—according to the latest figures from the Congressional Budget Office—is projected to reach 78 percent of the GDP by the end of this year, the highest level since 1950.5
The point is, I believe there are enough concerning details present in the economy and financial markets right now to assume—at the very least—that the extreme volatility we’ve experienced in the first half of the year isn’t going to lessen any in the second half. And remember, we saw similar patterns of volatility leading up to the major market drops that began in 2000 and 2007—so similar that, to me, it feels a lot like 2007 all over again.